Sunday, June 7, 2015

Don’t Just “Tap Your Retirement Savings”; Develop a Reasonable Spending Budget

This post is a follow-up to my post of August 31 from last year, “Managing Your Spending in Retirement—It’s Not Rocket Science” in which I set forth a four step process for managing spending:
  • Step #1 --develop a reasonable spending budget. 
  • Step #2-- determine your living expenses/needs.
  • Step #3—compare results of Steps #1 and #2 and make necessary adjustments
  • Step #4—follow this process at least once a year
In this post I will use an example to point out the benefits of following this process as opposed to applying some overly simplified spend-down strategy to your accumulated savings.  I will do this by revisiting Mary, the hypothetical retiree we looked at in the May 21 post from this year. 

This past week Anne Tergesen of The Wall Street Journal (WSJ) summarized several popular dynamic withdrawal strategies currently advocated by experts as an alternative to the 4% Rule in her article, “A Better Way to Tap Your Retirement Savings”.  None of the withdrawal strategies discussed in this article consider the retiree’s living expenses/needs or suggest that the retiree make necessary adjustments if expenses/needs don’t line up with the retiree’s spending budget.  They all involve relatively simple mathematical adjustments designed to spend down accumulated savings, with such adjustments applied the same to all retirees, independently of different life expectancy expectations, different other sources of retirement income, different desires for wealth transfers, different desires for future budget patterns, etc.  In my opinion, each of the approaches proposed in this article are clearly inferior to the four step process outlined above using the Actuarial Approach discussed in this website to develop the retiree’s spending budget/budgets. 

As discussed in our May 21 post, Mary is a 65 year old single female retiree with $1,000,000 in accumulated savings, a fixed-dollar pension benefit of $15,000 per year and she is receiving a Social Security benefit of $20,000 per year.  Mary has determined that her essential expenses are $50,000 per year.  She wants to leave $500,000 to her daughter or have that money available for long-term care or other expenses near the end of her life.   She also wants to set aside $100,000 of her accumulated savings for unexpected expenses.

In addition, for purposes of today’s illustration, we are going to assume that $7,000 of Mary’s essential annual expenses are attributable to medical expenses and prescription drugs and that Mary will be establishing a separate budget (within her total spending budget) for these expenses (because Mary expects them to increase at a faster rate in the future than her other essential expenses).  Also, we are going to assume that Mary desires to be more conservative with respect to the investments supporting her essential expenses (both her health-related expenses and her non-health related essential expenses) and has therefore decided to purchase an immediate annuity of $13,000 per year (with $6,000 per year allocated to her health related budget and $7,000 per year allocated to her non-health related essential expense budget).  

Mary’s Desired Budget Patterns

Mary expects her medical expenses to increase by inflation plus 2% and she plans to have these expenses payable for 30 years (or her life expectancy if greater), the recommended payment period under the Actuarial Approach. 

Mary expects her non-medical essential expenses to increase by inflation each year and she also plans to have these expenses also payable for 30 years (or her life expectancy if greater).

With respect to non-essential expenses, Mary is comfortable assuming that these expenses will not increase with inflation and will be based on her life expectancy (initially 24 years).  She realizes that this desired pattern will produce a lower non-essential expense budget (in both real and nominal terms) for her as she ages if all assumptions are realized. 

Number Crunching Under the Actuarial Approach

As noted above, Mary decides to buy an immediate annuity that gives her $13,000 in annual benefit.  This annuity costs her $205,629 at current annuity prices and leaves her with remaining accumulated assets of $794,371 ($1,000,000 - $205,629).

Mary uses the Excluding Social Security spreadsheet available in this website to determine that $107,500 of her accumulated savings plus a $6,000 per year fixed income annuity is expected to give her an annual spending budget of $6,988 per year increasing by 4.5% per year (based on the recommended assumptions and no amounts left to heirs).  This is close to her $7,000 per year estimate of health related expenses that are expected to increase by inflation plus 2% each year. 

Mary uses the spreadsheet again to solve for how much of her accumulated savings she will need to cover her non-health related essential expenses and her bequest motive/long-term care reserve.  Her target for this calculation is about $23,000 (to which she will add her Social Security benefit of $20,000).  She enters $22,000 for the fixed annuity ($15,000 pension plus the $7,000 recently purchased annuity allocated to non-health essential expenses), the recommended assumptions and $500,000 to heirs and determines that $288,000 of her accumulated savings will give her a constant real-dollar spending budget of $23,012 annually, to which she will add her Social Security benefit of $20,000 per year to give her an expected non-health essential budget of $43,012 per year (and $500,000 to her heir) if all assumptions are realized and Mary spends exactly her budgeted amount each year. 

Mary also has a separate budget for unexpected expenses in the amount of $100,000.

After budgeting for her future health related expenses, her non-health related essential expenses (including the desired amount to be left to her heir) and her future unexpected expenses, Mary has $298,871 of accumulated savings left ($794,371 - $107,500 - $288,000 - $100,000) for her non-essential budget.  She enters that amount in the spreadsheet with a 24 year payout period and 0% annual increases (and the other recommended assumptions) to develop a non-essential spending budget for her first year of retirement of $19,730. 

Her total spending budget for her first year of retirement, then, is $69,730 plus whatever amount she decides to spend from her unexpected budget account.  Assuming no withdrawals from her unexpected budget account, her $69,730 budget for her first year of retirement comes from the following sources:

  • Social Security: $20,000 
  • Pension:           $15,000
  • Life Annuity:    $13,000
  • Savings:           $21,730
  • Total:               $69,730

The total amount Mary expects to withdraw from her accumulated savings of $21,730 represents 2.74% of her accumulated assets of $794,371 (but only 0.35% of her non-health essential accumulated savings, only 0.92% of her health budget accumulated savings and 6.60% of her non-essential spending accumulated savings. 

By comparison, because the 4% Rule is just an accumulated savings withdrawal strategy (and not a budget setting strategy) that ignores the existence of Mary’s Pension and Life Annuity, it would suggest that Mary withdraw $31,775 from savings in addition to amounts she expects to receive from her pension, annuity and Social Security.   This would result in too much withdrawn from Mary’s essential budget accounts and too little withdrawn from her non-essential budget account to meet her spending objectives.  Using the Guyton Decision Rules with a 5% initial withdrawal rate would make things even worse in terms of meeting Mary’s objectives. 

Here is Mary’s Actuarial Balance Sheet under the Actuarial Approach.  The assumptions used to determine present values are the same as the assumptions used to develop the individual budget amounts.

(Click to enlarge)

Future Adjustments

In the future, lots of things will change.   These changes will include investment returns different from expected, spending different from budgets, inflation different from assumed, changes in mortality expectations, different expectations with respect to essential and non-essential spending, different expectations with respect to desired patterns of future budgets, different desires with respect to amounts left to heirs or expectations regarding long-term care, etc.  Since Mary is  re-visiting her retirement budget every year, she will be able to change her budget to accommodate these changes.  For example, if investment experience is more favorable than assumed, she can choose to beef up her amount left to heirs/reserve for future long-term care budget if that makes sense to her rather than increase her non-essential budget.  Unlike under the spend-down strategies featured in the WSJ article, Mary will have a significant amount of flexibility dealing with these changes in the future. 

Can These Other Approaches Do What The Actuarial Approach Does?

The short answer to this question is a resounding NO.  The approaches outlined in the WSJ article are spend-down strategies.  I recommend that they not be used if you want to develop a spending budget that reflects your individual situation and spending objectives.